CITY REVIEW: Minneapolis

Absorption and development continue to drive market activity. The Twin Cities real estate market is a mirror image of the area's thriving economy. Business expansion and rising personal incomes are fueling all sectors of the real estate industry.

"The Twin Cities is a healthy, vibrant market and, unlike some of the other markets around the country, it's not a boom or bust market, but very steady," says Arne Cook, regional director of First Industrial Realty Trust Inc. in Eden Prairie, Minn.

"The market remains healthy, yet our industry is beginning to show the appropriate level of caution," explains Rick Collins, president of the Welsh Cos. in Bloomington, Minn. "Concerns with the Asian crisis and the woes in our stock market have begun to cause companies here in Minnesota to exercise more caution in their expansion plans."

"The Twin Cities' market ranks among the tightest of the U.S. markets," says Clint Miller, a senior vice president and district manager for Grubb & Ellis, Minneapolis. "I think what underlies that is just a very strong local economy."

In the Twin Cities, where unemployment is a miniscule 2%, the robust labor market is one measure of the healthy economy. "We find ourselves talking about available labor supply as much as real estate," Miller adds.

Office The office market is enjoying robust activity with rents hitting record highs and overall vacancies dropping below 7%, while Class-A vacancies drop below 4%. The strong market conditions have produced an active construction cycle that in recent months has included the return of spec development. Almost 550,000 sq. ft. of new office space was added in the first half of 1998 in eight buildings in the southwest, west and southeast submarkets. An additional 734,500 sq. ft. is scheduled for completion during the second half of 1998, according to a market report released by Bloomington-based United Properties.

Major projects under way include United Properties' phased development of Centennial Lakes office park in Edina, Minn. The first four phases total 845,000 sq. ft. Opus Northwest LLC also has construction under way on its 500,000 sq. ft. Crescent Ridge office project in Minnetonka, Minn., while Carlson Real Estate Co. is preparing to break ground on 430,000 sq. ft. at 301 and 401 Carlson Parkway. The Minneapolis CBD is seeing the largest amount of development with 2.5 million sq. ft. under construction.

However, the bulk of that space is committed to large corporate tenants that include Target, Piper Jaffray and American Express Financial Advisors.

Despite the volume of new construction, the office market has not seen any warning signs of overdevelopment.

"If you look at the projects actually under construction vs. the inventory of space in the Twin Cities, new development accounts for only 3% to 4% of the market, which is pretty manageable," Miller says. (The Twin Cities' total multitenant office space is nearly 61 million sq. ft.)

"I don't think we can yet point to the market being overbuilt," agrees Mark Evenson, managing director for Cushman & Wakefield, Minneapolis. "Our track record shows that absorption has remained healthy and really accommodates any development that takes place."

The metro area has seen about 1 million sq. ft. of space absorbed each year for the past several years. Last year's absorption reached 1.4 million sq. ft. and, this year, absorption is expected to surpass that amount. In addition, today's suburban office projects are being built on a smaller scale. Current projects include Told Development's 180,000 sq. ft. phase two of Meridian Crossing in Richfield, Minn., and Liberty Property Trust's 168,000 sq. ft. Southwest Crossing project in Eden Prairie. Those projects are considerably smaller than suburban predecessors such as the three Normandale Towers in Bloomington, which range in size from 280,000 to 484,000 sq. ft. And, not all of the projects that have been proposed will get off the drawing board.

"If all the projects that have been announced should actually open, I believe we would have vacancy overhang that could create significant problems for owners," Collins says. "However, I don't believe all those projects will either come out of the ground or be opened."

This race to the finish line has pushed some prices slightly above replacement cost. A good example is Equity Office's acquisition this summer of Northland Plaza in Bloomington. The 297,000 sq. ft. Class-A building was sold for $47 million, or $158 per sq. ft. The Taylor-Simpson Group also participated in the bidding frenzy with its acquisition of the 725,500 sq. ft. Pentagon Office Park in Edina earlier in the year. The Class-C property sold for $59 per sq. ft.

"I think we will see some strategic selling going on. Investors are trying to bring more definition to their portfolios. You might even see a REIT or two sell something," Evenson adds.

Industrial The industrial market has seen healthy absorption and development again this year. More than 1.2 million sq. ft. of multitenant space has been constructed since December, and another 2.4 million sq. ft. is scheduled for completion by year's end. Absorption also was strong with more than 1.1 million sq. ft. absorbed in the first half of 1998, according to a United Properties report.

After a summer lull, industrial development is picking up heading into the fourth quarter. That slow down was prompted in part by large blocks of space coming on line in some submarkets. The southwest market, for example, had an excess of about 1 million sq. ft.

"The good news is that much of that space has been absorbed in the past 45 days," remarks Kent Carlson, a vice president with Ryan Cos. in Minneapolis. "Although development activity has been strong in recent years, that activity may start to shift in 1999."

Indeed, many developers seem to be more cautious this year. "We've already started to see more market-based development. I think people are being careful about the new projects they are bringing on line,"says Michele Foster, a senior director of real estate development for Opus Northwest. "But I don't think we're going to get into an overbuilt condition in the Twin Cities."

However, Foster adds that south of the river there has been some overbuilding, with more leasings and fewer new projects.

Developers also are beginning to shift their focus to different product types.

"You're seeing developers looking intelligently at submarkets and determining what the right product is that ought to be developed," Foster continues. "For example, the emphasis on bulk warehouse and office/warehouse construction is beginning to shift to office/showroom."

Bulk warehouse development accounted for 72%, or 2.6 million sq. ft, of new construction in 1997, and 58%, or 700,000 sq. ft., of new construction in the first half of 1998.

Meanwhile, the office/showroom sector is reporting the lowest vacancy rates at 7.7%.

The industrial market has become increasingly competitive in 1998 as new players such as Liberty and Duke Realty Investments Inc. (see page 44 for a profile of the company) have increased competition for acquisitions of land and buildings. Major 1998 sales have included Caliber Development Corp.'s 610,000 sq. ft. portfolio, mostly office and showroom space, which was purchased by Sentinel Real Estate Corp. for $63 per sq. ft.

AMB Property Corp. also purchased a 312,000 sq. ft. portfolio of office/warehouse and office/showroom properties from the Remada Co. for $47 per sq. ft.

"Minneapolis is an attractive market, and so it hits most of the REITs' radar screens," Carlson explains. "However, everybody, including developers, REITs and pension funds, are going to slow down a little bit."

Retail The retail market is the healthiest it has been in several years. Vacancy declined from 7.6% to 6.1% as of June 1998, and about 700,000 sq. ft. of space has been absorbed during the first half of 1998, according to a United Properties market study.

A cautious development market is likely to sustain those market conditions well into 1999. New retail projects also are slowing down as retailers are becoming more hesitant in their expansion plans due to a recent dip in sales, a volatile stock market and continued consolidation among retailers.

"Developers aren't building anything without the leasing," says Linda Zelm, a senior retail broker with United Properties and president of the Minnesota Shopping Center Association. For example, she adds, Opus is developing Arbor Lakes in Maple Grove, and the 600,000 sq. ft. project is already 100% leased.

Much of the big-box space that was vacated due to consolidations and bankruptcies has been absorbed, although recent vacancies include three Computer City stores and six stores left empty by Montgomery Ward & Co.

Retailers such as Wickes Furniture, Pep Boys, Golf Galaxy, Golfsmith and Gateway 2000 all are expanding in the Twin Cities. Rainbow and Cub Foods also continue to drive development with their new stores.

The competition from newly constructed centers is prompting many older properties to look at repositioning. West St. Paul's Signal Hills landed Wal-Mart as a new tenant, converting from an enclosed mall to a strip center format.

While retail in the St. Paul CBD continues to struggle, the Minneapolis market has stabilized. Minneapolis vacancies are at 10.9%, according to a United Properties market report, which goes on to say that the strong office market has helped increase retail demand - citing a new Target store downtown as one example.

"It's going to be wonderful to have a Target downtown," remarks Robin Keyworth, vice president of retail leasing and marketing for Brookfield Management Services LLC in Minneapolis. Brookfield is in the process of filling the 100,000 sq. ft. space in the Minneapolis City Center vacated in '97 by Montgomery Ward.

Major retail sales this year have included the 129,000 sq. ft. Ridgehaven Shopping Center in Minnetonka, which sold for $130 per sq. ft., and Glimcher Realty Trust's first acquisition in the Twin Cities market - the Northtown Mall in Blaine for $59 per sq. ft.

Multifamily The Twin Cities has long been a favorite market among multifamily investors because of low vacancies and strong rental rate growth. The overall vacancy rate for Twin Cities apartments is 1.8%, while average rental rates are up 4.2% to $628, according to data from Apartment Search Profiles.

Class-A acquisitions have been dominated by Equity Residential Properties and Avalon Bay Communities. Both REITs have been aggressively acquiring Twin Cities properties over the past two years, and combined, they have purchased more than 4,709 units. Such strong REIT activity has pushed up Class-A values, and sale prices now average $70,000 per unit. Still, those prices are expected to come down as REIT interest slows.

"REITs have slowed their buying largely because of current challenges on Wall Street," explains Bob Fransen, president of Fransen Real Estate Inc. in Edina.

Local buyers such as Bigos Investment and LaNel Financial Group have been actively acquiring Class-B and Class-C properties. That demand has increased values by nearly 10%. Class-B apartments have been selling for nearly $50,000 per unit, while Class-C properties are selling for about $34,000 per unit.

Activity in the B and C market also is expected to slow as many local investors take advantage of low interest rates to refinance their existing properties.

"I think we have two to three good years ahead of us," Fransen predicts. "Rents have been increasing at about 4.5% per year, and the new development has not been significant enough to impact market conditions. Because of the high costs of land and taxes, the majority of new development has been focused on upscale projects that warrant higher rents."

Hospitality Hotel construction is booming. The most dominant market continues to be the I-494 strip with its steady flow of hotel traffic generated by the Minneapolis/St. Paul International Airport and the Mall of America. That submarket has seen its hotel room supply increase 25% over the past two years with the addition of 2,500 new rooms.

Much of the development boom has been focused on the limited-service sector and extended-stay niche with properties such as Fairfield Inn, Courtyard by Marriott, Residence Inns and Homewood Suites. Yet the heavy construction in the limited-service sector has prompted developers to start looking at full-service opportunities.

The vibrant development market has pushed occupancies down slightly, while rents increased little during '98. And, according to a report from Marquette Advisors, year-end projections call for occupancies to drop to 67.5%, with ADRs rising to $84.